The Folly of S&P

The Rating Agency Didn’t Just Get It Wrong on U.S. Sovereign Debt

By Adam Hersh
Posted on August 12, 2011, 9:00 am

One week ago today the U.S. credit rating agency Standard and Poor’s sparked global fears of vast financial market turmoil by downgrading the U.S. credit rating from AAA to AA-plus after the U.S. markets had closed. Those fears were justified. When financial markets opened this past Monday in Asia, investors and taxpayers around the world watched a week’s worth of sharp gyrations in stock and bond markets unseen since the start of the Great Recession.

Yet the rating downgrade itself by S&P did nothing to dampen appetite for U.S. government bonds. Strong demand for U.S. debt this past week drove yields down to their lowest levels on record, saving taxpayers some $647 million.

Clearly, financial markets do not agree with S&P’s assessment. But this is due to more than just S&P’s admitted analytical errors in assessing the U.S. federal budget, or its infamous track record of awarding stellar ratings to the now-defunct investment bank Lehman Brothers and the still-struggling insurance company American International Group Inc. on the eves of their respective collapses in 2008.

Indeed, S&P’s decision to proceed with the downgrade after admitting to the errors left many observers wondering what good are S&P ratings anyway? Economist Paul Krugman asked of S&P: “in cases when the markets aren’t signaling worry but the agencies downgrade anyway, how often are they right?”

To answer Krugman: Never.

Typically, S&P ratings downgrades follow financial market reactions to deteriorating economic or political situations, but when S&P downgrades and the market does not signal distress, the record shows that no countries default. So what good are S&P credit ratings anyway if they only tell us what everybody else already knows? Let’s delve into the details because they demonstrate unequivocally that the reaction of institutional investors this past week in the U.S. Treasuries markets makes perfect sense.

S&P is a lagging indicator at best

Financial market participants vote with their feet. When investors see something they don’t like, they sell or demand more favorable terms for staying the course. Investor skittishness will be reflected in the movement of market prices. Selling of bonds and money market instruments will push interest rates up. By getting out of a country’s financial markets, investors will push the currency exchange rate down. And growing concerns about public-sector creditworthiness will mean that investors demand higher interest rates and shorter time to bond maturity on new sovereign lending.

Conversely, improvements in these two indicators—the flow of money to and the price paid on longer-dated bonds—reflect investor confidence in a country’s economic and political situation.

Adverse market movements—the consensus of investors around the world—typically foreshadow both trouble ahead and imminent credit rating downgrades. Mexican interest rates jumped 157 percent and the exchange rate fell 66 percent as the 1994-95 peso crisis unfolded in the three months before an S&P downgrade. In Thailand, interest rates spiked 58 percent and the exchange rate fell 42 percent as the 1997-98 Asian financial crisis unfolded in the three months prior to an S&P downgrade. Both Mexico and Thailand ultimately defaulted on their debts.

But setting aside a number of small island economies, of the 70 episodes of credit rating downgrades by S&P since 1975, there are 20 cases where no investor reticence can be seen in interest rates, exchange rates, or changes in the terms or availability of new sovereign credit in the run-up to downgrade.[1] In these cases the market did not vote against government creditworthiness, but S&P did. And in none of these cases—including those of Japan and Canada cited by Krugman—did governments default on their debts.

The availability of international economic data is uneven across countries, yet it is clear that in these 20 cases S&P downgraded government credit ratings when no evidence of financial distress was apparent and when no international systemic financial crisis was spilling over to unrelated countries. In the three months preceding these 20 downgrade episodes, money market interest rates (the indicator for which the most comprehensive data are available) fell on average by almost 11 percent.

The same is true for market interest rates on government debt, although comparable data are available for fewer countries. While exchange rates on average exhibited 5.7 percent depreciations across the 20 cases, in no case did these changes exceed thresholds of exchange rate volatility typically used to define exchange rate crises. In several cases, country exchange rates increased in value in the months preceding downgrade.

For new government borrowing on international capital markets, investors actually offered these governments improving terms, reflecting higher creditworthiness, in the period preceding S&P downgrade. Interest rates on new government debts issued to these countries fell by 5 percent, and the average length of lending to these governments increased by 15 percent—both indicators of declining risk as assessed by these governments’ creditors.

Meaningless but not costless

A credit rating downgrade reflects a change in the rating agency’s subjective assessment of the probability that a government will default on its debts. Not defaulting after a downgrade does not necessarily indicate the rating agency’s assessment was “wrong.” It is possible that S&P saw risk where the market did not, and their rating action prodded governments to get their fiscal acts together, thus avoiding subsequent defaults.

But such a conclusion is by no means obvious in the data. In fact, in the two years following these 20 S&P downgrades, gross government-debt-to-national-income ratios—an indicator to compare the relative size of debt burdens across countries—actually increased by 3.6 percentage points on average. Following the downgrades, most countries also experienced accelerated economic growth, increasing growth rates on average by 1.9 percentage points. All else being equal, faster growth should reduce the credit risk of government borrowing.

So while S&P ratings don’t appear to add any value over information on government creditworthiness already available in financial markets, being wrong in their subjective assessments poses real economic costs. Despite no prior indication of worry from financial markets, interest rates on new government borrowing increased by 15 percent on average for these countries. Higher interest rates on government borrowing mean more taxpayer money gets paid to financial investors rather than being spent on popular public services and investments.

Conclusion

In conclusion, Krugman’s hunch is right: S&P assessments aren’t worth too much with respect to the risk of sovereign default. This may explain why investors are still voting with their feet for U.S. Treasuries. Though they may help cause havoc in equity markets, S&P ratings don’t offer any valuable evidence on the safety of government debt.

Adam S. Hersh is an Economist at the Center for American Progress. Sarah Ayres, a Special Assistant with the Economic Policy team at the Center, provided research assistance.